I – The Fundamental Outlook

'Worse than expected'

There can be little doubt that current economic fundamentals are extraordinarily bad – the new stock phrase that accompanies almost every economic data release lately is 'worse than expected' – and this happens with expectations already lowered considerably.

A good way of following the evolution of expectations are WS estimates for S&P 500 earnings in 2009. These have gone from $98,-/ share about a year ago to $42/share now. There have been numerous revisions along the way, and economists are similarly revising their guesses as to economic data about to be released. It is generally agreed however, that knowledge of current economic fundamentals is not necessarily useful information with regards to what the stock market is about to do. The theory goes, not unreasonably, that the market tends to discount fundamentals ahead of their manifestation. However, as I have previously pointed out, this has generally not been true over the past decade or so. The stock market has most of the time acted as a coincident, and at times even lagging indicator, at least relative to official economic data.

Nevertheless, this does not change the fact that current fundamentals are a poor guide to market action over, say, the next four weeks for instance. There could be a rally in spite of a continuing deterioration in fundamentals, pinned on nothing but hope (the 'it's so bad it can only get better' thesis of investing), or pinned on a more reasoned approach that is based on the general idea that stocks are not merely a claim on earnings streams in the relatively near future – rather they are a claim on earnings streams into the far future.

Still, it would be good to have a crystal ball that informs us of future fundamentals. Can we make an educated guess? A large percentage of mainstream economists routinely disappoints in the economic forecasting department. One can certainly not rely on their timing, and neither can one rely on their general forecasting abilities. How many economists did in fact forecast the bust? Given that they have obviously a tendency to have too rosy an outlook even in the face of one of the worst contractions of the post WW2 era (thus the never-ending 'worse then expected' moments), why should one believe their estimates of when a bottom is likely?

A review of the known facts is in order.

1.we are in a secular bear market period, which will be marked by a secular contraction in p/e ratios, from the over-valuation seen in 2000 to an as-of-yet undetermined level of undervaluation.

2.Such a bear market is accompanied by recurring economic busts of increasing severity and duration – busts that are a mirror image of the preceding boom.

3.The current bust has a unique feature – the banking system appears on the brink of insolvency after having inflated credit willy-nilly for several decades (this is no exaggeration as the US total credit market debt / GDP ratio shows).

4.The authorities – fiscal and monetary, know only one recipe to counter the bust – inflate, inflate and inflate some more (in a combination of using the printing press and blatant Keynesian deficit spending; both methods have been thoroughly discredited throughout history in practice as well as theory, but are resorted to as a matter of course anyway).

If we only consider the above, it is clear that the current bust is of a different order of magnitude than its predecessors. While it was also precipitated by relatively tight (relative to the period preceding it) monetary policy for a short while (2004-2006), its major feature is the sudden incapacitation of the banking system – the very system at the heart of the practical implementation of the inflationary policy of the modern day industrialized welfare/warfare democracies.

It is important to note that the final inflationary boom – the real estate mania, respectively mortgage credit bubble, already saw the stock market decline sharply in real terms, even during the cyclical, nominal bull market phase. In other words, the only thing that drove the rally from the 2002/3 lows in stocks was the inflation of money and credit. This becomes evident indirectly by the expansion of margin credit and the enormous leverage taken on by hedge funds and investment banks during the period.

It was a levitation on hot air – based on the false confidence that everyone in the chain of credit that was extended during those years would be able to pay. The plunging Dow/gold ratio indicated though that it was an entirely illusory boom. Given how the authorities have reacted thus far to the bust – the central question then becomes 'will they be able to create another inflationary boom?' In other words, can reality be masked again by a new illusion of wealth based on the inflation of money and credit?

This seems a tall order – since there is a limiting factor in the real world that doesn't lend itself to eternal exploitation – the pool of real funding. It matters not how many pieces of paper or electronic chits the Fed prints up in its balance sheet expansion – the amount of real resources available to the economy can not be changed by that.

The reality of the banking sector's balance sheet implosion is currently partly camouflaged via the Fed's interventions, but it can likewise not be winked out of existence. What the banks now lack is capital – as their existing capital has been eaten away by too many securities turning worthless, and too many debtors defaulting. The problem is that everybody else lacks capital too, or owns capital for which there is currently no use and that can not be profitably employed in its current incarnation (a number of car factories come to mind, for example).

We can conclude that the bust will be intense, and investment strategies will have to be adapted accordingly.

The time of 'buy and hold' has been over for ten years already, even though a surprising number of analysts still seems to cling to this mantra of the bull market. Perhaps they should have specified 'buy and hold t-bills', since those have outperformed the stock market by nearly a cumulative 40% over the past decade? Likewise, it appears the 'money multiplier' has degraded into a 'money divider' as Bob Hoye has recently put it.

II – The Technical Conditions

In terms of the stock market's technical condition, it is surprisingly poor. Why 'surprisingly'? There are quite a few historical examples of a market crash in the fall, both in the 20th and 19th century. One common feature of all those crashes has been a subsequent rebound that went hand in hand with a lessening of credit concerns and as a rule managed to retrace at least 50% of the preceding crash wave. A notable exception to the rule was the 1987 crash that happened in the broader context of a long secular bull market – in this case, the rebound erased over 100% of the crash wave before running into temporary trouble. The point is, it is unusual to see the market as weak as it has been so far in January right after an autumn crash.

The S&P 500 Index with Elliott wave labeling. Wave 4 is likely still in progress – click on chart for larger image.

It is possible, even likely, that the expected rebound will still happen with a delay. However, given the unusual action up to this point, one must be prepared for the alternative as well – a further wave of selling. As previously discussed, the market lends itself to a relatively obvious Elliott wave count since the October 2007 high. The corrective action since the 'wave 3' low has been a bit more difficult to interpret, which is a common feature of corrective waves, as there are a great many variations possible. From this standpoint, the main question is 'are we still in corrective wave 4' or 'has wave 5 down already begun'.

One of the arguments in favor of a rebound is the fact that a number of market participants are reportedly simply waiting for the current horrible earnings season to be over before committing new capital. The earnings season is regarded as being chock-full of the same event risk that is currently dogging economic data releases – the 'worse then expected' syndrome.

Ironically, an argument can be made that the market is actually not 'oversold', as Carl Swenlin shows here in this 'chart spotlite' at decisionpoint.

From experience though it can be stated that the shorter term the time frame considered, the more difficult it is to forecast the likely outcome. If acting in favor of one outcome, one should always prepare a plan of action for the opposite outcome. Assuming that the rebound will resume, the question of which sectors are most interesting comes to the fore. Below are a number of 'relative strength' charts. They show how different market sectors have performed relative to the S&P 500 over the past year – whereby their performance since the November low is what interests us here.

Airlines have outperformed the rest of the market since the peak in oil prices. Note however that this streak seems potentially endangered now, which may be a hint that energy prices are about to rebound. Option traders are optimistic on airlines. put/call open interest across the sector is the lowest in the past year, and short interest in the group's most prominent component stocks has declined sharply – click on chart for larger image.

Banks have once again strongly underperformed the market of late. As can be seen here, the BKX-SPX ratio chart broke the neckline of a head-and-shoulders formation, but may already have met the target range, and is now deeply oversold. Near term, we would avoid this group from both the short and long side. There's no need to try to bottom fish given the industry's sorry state and the risk of a snap-back rally is too great to make it an enticing target for shorting. This sector is best left to those who want to play hero. Interestingly, the sector-wide p/c open interest ratio of 0,87 is actually very low compared to the readings over the past year. Note: as the market cap weighting of financial stocks declines, their influence on the market-at-large declines commensurately – click on chart for larger image.

The biotechnology index has outperformed the market since last spring. The sector-wide put/call open interest at 0,62 is fairly high compared to readings over the past year, which is to say, option traders are rather pessimistic on this group now. Good relative performance coupled with pessimism is a good omen for this sector – click on chart for larger image.

The Broker Dealer Index has made no headway relative to the market since the November low, and remains in its longer term down-sloping channel. Short interest remains high, but option traders are curiously optimistic on the group. We see no reason to engage with any financial stocks, given that their outlook remains bleak. Financials should be watched for signs of getting overbought, at which point they will likely continue to provide shorting opportunities for nimble traders – click on chart for larger image.

There's nothing remarkable about the performance of the Chemicals Index either, which is essentially also going nowhere relative to the S&P, following a streak of under-performance since the fall. As a cyclical sector it suffers from the sharp deterioration in the economy – click on chart for larger image.

Due to containing a large weighting of Wal-Mart (WMT), the MS consumer index CMR has outperformed the broader market. The discretionary consumer ETF XLY may be the better gauge in this case – it has flat-lined relative to the broader market, which is to say, it has performed just as badly. In short, there are neither fundamental nor technical reasons at this time favoring this sector – click on charts for larger images.

Disk Drive stocks have begun to outperform since the November low. It remains to be seen if this can be kept up due to the fundamental challenges faced by this industry. Still, storage is perhaps one of the better sub-sectors in the tech hardware world – click on chart for larger image.

There is always a lot of worry about the pipelines of the large pharmaceutical firms, and the sector has for a long time been a downside leader (it was one of the first groups to break below its 2002 lows). However, strong balance sheets, high dividend yields and an intriguing streak of outperformance in recent months make this sector interesting – click on chart for larger image.

Computer Hardware shows strong relative performance since the November low, mostly due to component stocks like IBM and HPQ. It remains to be seen whether this can be kept up – option traders are optimistic, and there are a number of fundamental reasons to remain wary – click on chart for larger image.

Internet stocks are helped by GOOG's less than horrible recent earnings report. There is however nothing especially exciting here – click on chart for larger image.

The upcoming period of seasonal strength in energy could help both the XOI and OSX. XOI currently looks better on a relative strength basis, but the OSX is traditionally lagging, and usually has a higher beta, so it could play catch-up – click on charts for larger images.

RTH's relative strength is helped by Wal-Mart (WMT). For obvious reasons, retail stocks should probably be avoided. The best thing that can be said for them is that most are technically oversold by now – click on chart for larger image.

Networking stocks have been going nowhere in particular relative strength-wise in a wide channel – click on chart for larger image.

The Semiconductor sector has recently strengthened as well, but the group remains suspect for fundamental reasons – click on chart for larger image.

The relative strength chart of the telecommunication group is intriguing, as it is attempting a break-out – click on chart for larger image.

The point of this exercise is basically, 'if you have to be long something, choose whatever shows good relative strength' . Two of the biggest reasons why I personally have become a bit more constructive vis-a-vis the stock market in the near term can be found below (please note, I remain medium to long term bearish):

The US dollar index appears to have built a bearish flag – a decline in the dollar would likely go hand in hand with rising stock prices – click on chart for larger image.

The safe haven buying that supported the huge rally in T-bonds has subsided. The initial correction target has been met, so a rebound is increasingly likely. However, the bearish influence the bond market had on stocks has clearly lessened (currently, lower interest rates on long term government bonds are a bearish, not a bullish sign for stocks) – click on chart for larger image.

3. Gold and gold stocks

I'm looking at gold and gold stocks in a separate section because the gold stocks are currently the one market sector with the best fundamental and technical outlook.

On the daily chart we can see that a big test lies just ahead for gold – the resistance in the 920-930 area that has stopped the previous rally attempt. It seems likely that this won't be overcome on the first attempt. Breaching this resistance would be a a very positive sign – click on chart for larger image.

Gold keeps streaking higher against the S&P index. At the moment it is attempting a new break-out in relative strength terms – click on chart for larger image.

Gold has risen enormously relative to crude oil. Energy is a major input cost for gold miners, so this is a boon for their profit margins. Interestingly, Wall Street analysts are generally very lukewarm toward gold stocks – click on chart for larger image.

Since the low was put in, the HUI has risen sharply vs. the SPX, but the relative strength chart is now running into short term resistance – click on chart for larger image.

To reiterate something I have mentioned before: the gold sector will probably be the only major market sector to deliver earnings growth in coming quarters. In spite of this, it is strangely unloved by many in the Wall Street analyst community. Let me name a few examples.Newmont Mining (NEM) for instance currently sports 4 'strong buy', one 'buy' and 8 'hold' ratings ('hold' is the Wall Street euphemism for 'you should have sold it yesterday'). Put/Call open interest on the stock has soared in the past few months, from roughly 0,60 to about 1 now.Barrick Gold (ABX) has 6 'strong buy', 1 'buy' and 7 'hold' ratings; put/call OI on the stock has also soared lately.Goldfields (GFI) has 1 'strong buy', 2 'hold', and 1 'sell' rating. Note in this context that the price of gold in South African Rand is at a new all time high (!), while GFI trades about 65% below its former all time high. p/c OI on the stock has doubled of late.Harmony Gold (HMY) has 1 'strong buy', 1 'hold' and 1 'strong sell' rating. I'm not sure who dispensed the 'strong sell', but the company's balance sheet is stronger than it has been in years, it has 5 growth projects in the pipeline, and the fattest margins in at least 5-6 years.You get the drift – Wall Street isn't exactly brimming with love for gold stocks. This is of course excellent news for anyone holding them, as it increases the chance for future upgrades.

Gold in South African Rand. This is a nice, steady bull market progression. The profit margins of South Africa's gold mines are soaring along with it – click on chart for larger image.

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